The CDS Darwin Awards

Most financial publications - whether Euromoney, Institutional Investor, Finance Asia or similar - sell a lot of copies by handing out awards. Advisory and flow guys get awfully excited about their rankings for underwriting bonds, equities, and for their FX dealing skill. For the latter and most of the flow business it is a little known fact that given the OTC nature of the business it is very hard to objectively assess and often comes down to how popular the sales force is and how good they are at harassing clients to fill in exaggerate volume in the surveys. Now Team Macro Man is no expert on liquidity, but FX markets sure don't trade like they have $4trn of volume in them!

Not to be outdone, the Team has decided to establish what will no doubt be the first of many awards for foolish market conduct: The CDS Darwin Awards. In recent history, many of the heroes of investing are the guys who got long protection in size against the goliaths of the financial world and raked it in. These contrarian geniuses (or is that genii...?) have earned their place on the cover of Bloomberg by betting against a bubble for a hundred bps or less a year and winning.

The CDS Darwin Award is not for these people: it is for those weak souls who in the face of the underlying equity falling, losing a truckload of cash say “AHA! As a solution to me investing in businesses I don’t understand and getting a trip to investing Oz I will absolve myself of all my screwing up by then trading a product I don’t understand! That will surely make it all good again!”.

No, it won’t. CDS markets are some of the spivviest around largely because they have a few natural sellers and a *lot* of natural buyers when things are going to hell. Overshoot is the order of the day and the idea that CDS markets are anywhere near complete or as unbiased predictors as compared to, say, bond futures or equities is laughable (Team Macro Man will write a more detailed post on this shortly...). They are a protected workshop of i-banks, structurally, and that is largely how they work. In the middle of a crisis there are two likely outcomes: you either cannot get an offer for protection or, if you are, you are probably having your hands cuffed to your ankles by the dealer – you just haven’t realized it.

In 2008, the CDS Darwin Award was awarded to buyers of Glencore:

At some point the investing public decided to apply haircuts to Glencore and Noble Group’s working capital determining that the trading companies were underwater. Sadly someone didn’t inform these people that assets and liabilities for these companies are generally matched and thus tend to self-liquidate: unless we really are going back to the stone age you could collect decent cash with these things in runoff.

This year's Award, of course, goes to recent buyers of BP Plc. 1yr CDS (see below chart - traded over 1000bps intraday). Now, aside from any fundamental considerations of financial analysis, the fact that the $20bn fund is payable over 3 years, etc etc, ask yourself this: what is BP worth to a US politician dead versus alive? The answer: not that much. If the firm was put in liquidation, payment of claims would come to a standstill as these claims would not be considered normal business operations that need to be funded. Assets could not be sold unless they were “clean” and then only at bargain basement prices. Similarly, the UK and foreign subsidiaries would go into total lockdown as they go through a bankruptcy that looks more like Chapter 7: administrators in, very little cash out. Fishermen from Alabama would join the back of the line with other senior creditors. Compare that to keeping the firm alive, paying out claims as they are filed as opposed to validated by a court of law and thus keeping the general public (and the Democrats' election prospects) happy.

So whatever your estimate of BP’s damages (pick a number, any number…) no one is incentivized for this company to go down. For those who are familiar with these kind of liability disaster zones look no further than the likes of James Hardie:

It paid in full and on time as it paid out claims related to asbestos deaths from 2006 onwards. Now it looks pretty healthy for a building materials company which might give some indication as to what BP shareholders might get for their patience from here on in.

Team Macro Man would like to open the nomination for other market Darwin Awards to our readers.